Is the Economy Returning to Normal? Will the Fed Follow?

March 7th, 2015
in contributors

Macro Strategy Review from Forward Markets, March 2015

by Jim Welsh with David Martin and Jim O'Donnell, Forward Markets

U.S. Economy

As noted in the January Macro Strategy Review (MSR), we expected U.S. gross domestic product (GDP) to slow in the first half of 2015 from the 5.0% rate in the third quarter of 2014, as dollar strength began to slow exports and wages failed to accelerate.

Follow up:

It appears we were too optimistic. In its first estimate of fourth quarter GDP, the U.S. Department of Commerce pegged growth at 2.6%, bringing total 2014 growth to 2.4%. This marks the ninth consecutive year in which the economy failed to grow at 3% or better. According to the U.S. Bureau of Economic Analysis, this is the longest stretch of sub-3% growth since data began being recorded in 1930. The employment cost index, a broad gauge of wage and benefit spending, rose a seasonally-adjusted 0.6% in the fourth quarter and 2.2% for the year 2014. Wages and salaries, which account for 70% of compensation costs, rose 2.1% while benefits rose 2.6%. During the 2001-2007 expansion, the increase in annual compensation averaged 3.5% while during the current expansion, which began in June 2009, compensation has averaged just 1.9%. If this is the best middle-class economics has to offer after almost six years of recovery, then a change in course seems overdue.

Contrary to most economists, after the price drop in oil we didn’tthink consumers would spend most of their gas savings and it turns out they haven’t. According to a survey of 4,500 consumers by Visa Inc. in early January, consumers are saving half of their newfound wealth from lower gas prices—using 25% to reduce debt and spending the remainder on small purchases like groceries, clothing and fast food. The personal savings rate jumped from 4.3% in November to 4.9% in December, according to the Commerce Department. These statistics help explain why retail spending, after excluding gas purchases, were flat in January after falling 0.2% in December.

Since October, the Institute for Supply Management’s (ISM) overall purchasing managers index (PMI) of manufacturing has fallen from 57.9 to 53.5 in January, with each successive month showing more slowing. Readings above 50.0 indicate expansion, so while January’s tally is still positive, it was the lowest level since January 2014 when the polar vortex chilled the economy. As we expected, the stronger dollar is progressively slowing exports. The ISM exports index, a subset of the larger index, fell to 49.5 in January after 25 consecutive months above 50.0. Business investment fell 0.6% in December, marking four consecutive months of decline for the first time since 2012. The string of less-than-stellar economic reports is captured in the Citi Economic Surprise Index, which has fallen from near 40 in late December to -28 as of February 19. Consumer spending and income, manufacturing activity and business investment ended 2014 on a soft note and showed no signs of picking up during January. Although the Commerce Department will revise its initial estimate of fourth quarter GDP, it is unlikely the economy grew faster than 3%, and it likely won’t in the first quarter either.

In the September 2014 MSR we included a section titled “Human Nature and the Fine Line Between Helping and Dependency” and the impact of the Emergency Unemployment Compensation (EUC) Program. The EUC program was expanded in 2008 to provide unemployment benefits for up to 99 weeks once the 26 weeks of state benefits were exhausted. It was extended 12 times by Congress through 2013. We thought the EUC program risked the unintended consequence of providing a disincentive for some people to look for a job since they would be able to collect benefits even if they hadn’t searched for a job. By the end of 2013, the recovery that began in June 2009 was four and half years old and the EUC benefits for 1.3 million unemployed people had ended. Another 1.9 million recipients received their last check in the first six months of 2014. We surmised if just 10% of the 3.2 million people who could no longer count on their EUC checks were more motivated to find a job in the first seven months of 2014 it would add 46,000 jobs to the monthly average. In the first seven months of 2014, job growth averaged 230,000 new jobs per month, or about 45,000 more than the 2013 monthly average of 185,000. Potentially, the suspension of the EUC program might have accounted for most of the increase in jobs. It turns out we were probably right about the unintended consequences of the extended EUC program.

In January, the nonpartisan National Bureau of Economic Research (NBER) published research by economists from the University of Oslo, the Institute of International Economic Studies and the University of Pennsylvania. These economists studied how the variation in job growth between states offering more generous benefits than neighboring states impacted job growth after the EUC program ended. They went so far as to compare adjacent counties in different states whose economies are otherwise equal except for each state’s unemployment benefits. They found the states that experienced the largest job growth increase after EUC benefits were eliminated were the states that had been targeted with the most generous federal benefits, since those states had suffered more from the recession and weak recovery.

The research determined that paying people not to work meant they had less incentive to find a job. The researchers also concluded that employers were less inclined to offer jobs paying wages in excess of what EUC recipients were already receiving for doing nothing, since it would add to their labor costs. In effect, companies were competing with EUC benefits to get workers. As we noted last September, the allure of free money and total free time versus getting a job, paying taxes and incurring commuting costs is an economic decision. A paid vacation via the federal government leads some people to decide their quality of life is better, even if they have to get by on a little less income. It seems easy to rationalize a free lunch on the government since some EUC recipients weren’t hurting anyone specifically (i.e., stealing someone else’s lunch).

NBER concluded that the net impact of the elimination of EUC benefits at the end of 2013 and in the first half of 2014 led to the creation of 1.8 million new jobs. This means that ending the EUC program was directly responsible for 60% of the 3.05 million new jobs created in 2014. As we noted last September, it is important and valuable for a society to help those in need. However, Congress must also be aware of the unintended consequences of government programs that can result in less production in the overall economy and create dependency for some recipients on the programs that were designed to only provide temporary help. In late 2013 as Congress was debating the end of the EUC program, the White House Council of Economic Advisers forecast that ending the EUC program would lower aggregate demand and lead to a direct loss of 240,000 jobs. Sometimes ideology trumps common sense, which both political parties seem to remind us frequently. The employment report for January was solid and has led more economists to expect the Federal Reserve (Fed) to raise interest rates in June rather than later in 2015. (This projection is as of February 24 since we don’t yet know the details of the March employment report.) We think there is too much slack in the labor market for the Fed to act in June—that is, if their decision is based solely on labor market conditions. Despite a series of solid job gains in recent months, average hourly earnings rose just 2.2% in January. The dormant pace of wage growth since 2010 is a reflection of excess slack in the labor market, even though the official unemployment rate (U3) has improved significantly over the past two years.

The U3 unemployment rate has fallen from 8.0% in January 2013 to 5.7% in January 2015. Many economists, including members of the Fed, have noted that the current 5.7% unemployment rate is low by historical standards. While the U3 gets the headline every month, the U6 unemployment rate, an alternate measure of the labor market, probably provides a better measurement of the actual amount of slack in the labor market. The U6 includes those working part time who would prefer full-time employment. In January, there were 6.8 million workers who fit into this category—a significant group. The U6 rate also includes those who are marginally attached to the labor market, since they still want to work but have become discouraged. In January there were 6.5 million discouraged workers who were still looking in from the outside of the workforce. When these 13.3 million workers are included in the calculation, the amount of slack in the labor market soars from the 5.7% official January U3 unemployment rate to 11.3%—a spread of 5.6%.

To determine if the spread of 5.6% is excessive, we analyzed U3 and U6 data going back to 1994 (when the data for the U6 first became available) and compared the current spread to prefinancial crisis rates. To determine the impact of the financial crisis on the U3-U6 spread, we calculated the average spread from January 1994 through August 2008 (just before Lehman Brothers filed for bankruptcy on September 15, 2008, marking the start of the financial crisis), and arrived at an average of 3.85%. Clearly, the current spread of 5.6% is well above the long-term average. Since the Fed would like to see an increase in wage growth, we next analyzed whether the U3-U6 spread had any impact on wages. Our assumption is that wages are likely to rise faster when the U3-U6 spread is less than 3.85%, since that would imply a degree of tightness in the labor market. When the U3-U6 spread is above 3.85%, it would suggest there is excess slack in the labor market and thus wages would increase more slowly. To establish a benchmark for average annual wages and exclude the impact of the financial crisis on wage growth, using data from the Federal Reserve Bank of St. Louis we calculated the average annual gain in monthly wages from January 1994 through August 2008, giving us 3.32%. We then compared the data to the U3-U6 spread from January 1994 through January 2015 to see if wages rose faster than the 3.32% average when the spread was less than 3.85% and if wages rose slower than 3.32% when the U3-U6 spread was above 3.85%.

We expected that changes in the U3-U6 spread would precede changes in wage growth by some period of months based on the trend in the spread, especially as the spread rose above and dropped below the 3.85% average. In the 12 months between June 1996 and May 1997, wages grew 0.29% above 3.32% as the U3-U6 spread narrowed from 4.30% to 3.85%. Then, once the U3-U6 spread fell below 3.85% in May 1997, wage growth accelerated and averaged 0.72% above 3.32% in the following 12 months. Clearly, after the labor market conditions tightened, wage growth responded strongly and remained healthy during the next four years. In October 2001, the U3-U6 spread widened above 3.85%, signifying that labor market slack had increased. Just two months later in December 2001, wages began to weaken and remained soft during the “jobless” recovery of 2003-2005. In April 2005 the U3-U6 spread tightened back below 3.85% and nine months later in February 2006 wages started growing faster than the 3.32% average. Wage growth held up until just before the onset of the financial crisis. In January 2008, the U3-U6 spread rose above 3.85% and stayed modestly close to average through August 2008. After the financial crisis exploded in September 2008, the U3-U6 spread soared and it didn’t take long to impact wages. Annual wage growth peaked in October 2008 at 3.92% and fell below the 3.32% average in April 2009. The U3-U6 spread remained quite wide, expanding until September 2011 when it peaked at 7.30%, a full 3.45% above the 3.85% average. Between September 2011 and October 2012, the U3-U6 spread only narrowed to 6.90% and wage growth didn’t stop falling until October 2012. Since October 2012, the U3-U6 spread has gradually improved but it is still fairly wide, which likely explains why annual wage growth has not risen faster than the 2.2% rate of the past few years.

The Federal Reserve began to increase the federal funds rate in June 2004 when the U6 rate was at 9.50%, far less than the current rate of 11.30%, and when the U3-U6 spread was almost at the 3.85% tipping point. Between June 2004 and April 2005, the U3-U6 spread fluctuated between 3.70% and 4.00%, hovering right around the 3.85% average, and wage growth improved from 2.02% to 2.69%. In January 2015, the U3-U6 spread was 5.60%, well above the 3.85% tipping point between too much labor slack and too little. This data suggests that wage growth in coming months is likely to remain muted until the spread narrows considerably. While a further decline in the U3 unemployment rate is sure to make some Fed governors uncomfortable that the pressure is on to raise rates, we think a majority of the Federal Open Market Committee (FOMC) members will take a more holistic view of the labor market that includes the U6 unemployment rate and the absence of solid wage growth.

If the Fed does raise interest rates in June, it won’t be due to tightness in the labor market.

Federal Reserve

Based on the Federal Reserve’s dual mandate of stable inflation and full employment, there is no reason for the Fed to increase rates as soon as June. The Personal Consumption Expenditures (PCE) Index, which excludes food and the impact of energy prices, rose just 1.3% in January. This is well below the Fed’s 2% target and is unlikely to change much before June. As we have shown, the U3-U6 spread is very wide and wage growth is still well below the average of every other post-World War II recovery. It would be hard to argue that the labor market has reached anything close to full employment. Under these conditions, why would the Fed raise interest rates? In an interview with the New York Times in early February, Charles Plosser, president of the Federal Reserve Bank of Philadelphia, made the following statement:

“If monetary policy…is distorting what might be the normal market outcomes…At some point the pressure is going to be too great. The market forces are going to overwhelm us…And then you get that rapid snapback in premiums…and that’s going to cause volatility and disruption.”1

This statement reinforces the philosophical reason why the Fed should move gradually to increase rates before it falls behind the curve and the pressure is too great. After all, the Fed has maintained interest rates at a crisis level even though the recovery will be six years old in June. On February 3, James Bullard, president of the Federal Reserve Bank of St. Louis, said he’d like the Fed to get rates “off zero” and remove the language stating it will be “patient” about raising rates.2 The discussion on whether to remove the word “patient” at the March 17-18 FOMC meeting is likely to be lengthy and will make for interesting reading after the minutes are published.

While the Fed has said it is data dependent in its rate decision in the short run, it does have a longer-term reason for needing to increase the rate. Prior to the financial crisis, manipulating the federal funds rate was the Fed’s most powerful policy tool—something it has lost with its zero interest-rate policy in place since 2008. Sooner or later, the U.S. economy will experience another recession or a meaningful slowdown and the Fed will want to have the capacity to lower the rate to stimulate the economy without having to resort to quantitative easing (QE) or negative interest rates. Balancing its short-term response to incoming data with the longer-term need to increase the funds rate is likely to prove difficult since the financial markets have become overly dependent after years of accommodative policy. Each peak in the federal funds rate since 1981 has been lower. We contend that this has occurred because each new dollar of debt is generating progressively less than $1.00 of GDP growth and the debt-to-GDP ratio has increased from $1.65 in 1982 to $3.50 today. Even if the Fed is able to increase the federal funds rate in coming years, the high for this economic cycle is likely to be well below 4.0% since each 1% increase will balloon the federal budget’s interest costs by more than $150 billion annually, according to the Congressional Budget Office.

The 18% increase in the value of the dollar since last May is already a headwind for U.S. growth and inflation. The resulting higher cost of U.S. goods is curbing export growth for U.S. firms and forcing them to compete by lowering the prices of their merchandise and services both abroad and domestically. In December, exports fell 0.8% and export prices tumbled 2.0% from November, the largest decline since October 2011. For countries exporting their goods into the U.S., the decline in their currencies relative to the dollar enables them to lower their prices. In January, import prices, excluding petroleum, fell 0.7% from December—the largest one month decline since March 2009—and were down 1.2% from a year ago. As we have noted in prior MSRs, Japan and the European Union (EU) are exporting deflation through the devaluation of their currencies and this fall in import prices is just one outcome. U.S. consumers have responded to lower priced imports by buying more. In December, imports soared 2.2% from November, causing the trade deficit to jump 17% to $46.6 billion.

The relative strength of the U.S. economy compared to the eurozone and Japan and the perception that the Fed could raise rates in June certainly added fuel to the dollar’s rally, especially after U.S. GDP grew 5% in the third quarter. However, as we have discussed in a number of MSRs since last May, the euro represents 57.6% of the dollar index, so the rally in the dollar has primarily been the result of weakness in the euro. The decline in the yen has also contributed to the dollar’s strength, but it is only 13.6% of the dollar index. The fact that the euro and yen currencies weakening is the main driver of the dollar’s rally poses a problem for the Fed since it means the rally has been more of a response to the monetary policy of the European Central Bank (ECB) and Bank of Japan (BoJ) than the Fed’s.

During the January 27-28 FOMC meeting, Fed members discussed and expressed concerns about the dollar:

“The increase in the foreign exchange value of the dollar was expected to be a persistent source of restraint on U.S. net exports, and a few participants pointed to the risk that the dollar could appreciate further….Others observed that insofar as the shifts reflected concerns about growth prospects abroad or were accompanied by a stronger dollar, the implications for U.S. monetary policy were less clear.”3

Actually the implications are quite clear to us. Even if the FOMC chooses not to raise rates in June, the dollar may appreciate anyway as the ECB, BoJ and other central banks ease their monetary policy to revive their domestic economy and push deflation from their borders, as a number have done in recent weeks.

Even though the FOMC may want to move away from its zero interest-rate policy, there are more reasons to remain “patient” even if they remove the word from the March FOMC meeting statement. The Fed’s own model suggests that a 10% appreciation in the trade-weighted value of the dollar shaves about 0.75% off the level of GDP over a two-year period. The trade-weighted dollar index has risen by 15% since last summer, which suggests a drag of more than 1.0% to GDP. Partly as a result of the rally in the dollar, the pace of GDP growth has moderated, core inflation is well below 2% and there is plenty of slack in the labor market. A stronger dollar in response to a rate increase would only strengthen the headwind already evident in the fall off in exports, decline in import prices and increase in the trade deficit.

Finally, we can’t help but marvel at Charles Plosser’s statement:

“If monetary policy is distorting what might be the normal market outcomes…”4

We find this statement to be exceedingly disingenuous. Would the stock market and bond yields be at their current levels if monetary policy had been normalized in 2011 or 2012? Ha, not likely!


The ECB is launching its “Expanded Asset Purchase Programme” (or QE program) this month, which will include its current purchases of banks’ covered bonds and asset-backed securities (roughly $15 billion), new purchases of eurozone government bonds and debt from the European Investment Bank and the European Financial Stabilization Facility. In total, the ECB will buy about $70 billion of paper per month through at least September 2016. To avoid distorting what might be normal market outcomes, the ECB won’t buy more than 25% of any bond issue or 33% of the marketable debt of any issuer. The ECB explained why it was launching its version of QE when it announced the program on January 22:

“Asset purchases provide monetary stimulus to the economy in a context where key ECB interest rates are at their lower bound. They further ease monetary and financial conditions, making access to finance cheaper for firms and households. This tends to support investment and consumption, and ultimately contributes to a return of inflation rates towards 2%.”5

In the short run, inflation is not likely to comply. The ECB does not exclude energy when it calculates inflation as the U.S. Federal Reserve does, so the plunge in oil prices has disproportionately impacted the eurozone’s Consumer Price Index (CPI). In January 2015, the eurozone CPI fell 0.6% from January 2014, the biggest drop in more than five years. The core rate of inflation, which excludes energy, was up 0.5% in January, comfortably above CPI inflation but well below the 1.62% long-term average of core inflation. Bond yields in the eurozone are already near historic lows, so the ECB’s QE program will only have a marginal impact on economic growth.

While the ECB’s QE program may help keep interest rates down in the eurozone, it will not address the structural issues that are primarily responsible for the economic malaise that burdens many eurozone countries other than Germany. In the fourth quarter, the GDP of the 19 nations in the eurozone grew at an annual rate of 1.4%. Most of the growth came from Germany, whose GDP grew at a 2.8% annual rate. Since Germany represents 29% of eurozone GDP, it contributed 0.8% to the 1.4% increase, or 58% of the total. France is the second largest eurozone economy and its GDP grew 0.4% while Italy experienced no growth. Combined, France and Italy represent 37% of eurozone GDP. As long as France and Italy remain deadweight, growth in the eurozone economy is likely to remain muted and overly dependent on Germany.

In order for France and Italy to become more competitive in global markets, they must enact labor market reforms that provide companies more freedom to manage their businesses, including the flexibility to close unprofitable plants, lower labor costs and increase productivity. The ECB has encouraged a 19% decline in the euro’s value versus the dollar since last May. A cheaper euro will make France and Italy more competitive outside of the eurozone, but not inside it. Germany derives 50% of its GDP from exports, so the depreciation of the euro will disproportionately benefit Germany since it is the most productive country in the eurozone. The depreciation of the euro and the ECB’s QE program allows the politicians in France and Italy to duck and postpone any real labor market reforms, dampening the long-term potential of their economies.

Germany’s productivity advantage within the eurozone can be seen in the performance of its stock market since the euro began to fall last May. The German DAX has jumped 15.64% since last May versus a gain of 8.36% in France’s CAC 40 and just 0.28% in Italy’s stock market. The impact of the euro’s fall and the dollar’s 19% appreciation versus the euro since last May has been significant. For U.S. investors, the 15.64% gain in the DAX becomes a loss of -5.05%, the 8.36% gain for the CAC 40 becomes a deficit of -10.89% and the small 0.28% return in the Borsa Italiana becomes a -17.55% loss. According to Bank of America Merrill Lynch, currency market volatility has hit its highest noncrisis level in 20 years. This fact underscores the necessity of hedging currency market risk when investing in international markets. Despite the rally in many European stock markets in anticipation of the launch of the ECB’s QE program, many markets appear relatively cheap, especially when compared to the U.S., as based on Robert Shiller’s cyclically adjusted price-earnings (CAPE) ratio. The current CAPE ratio for the U.S. is 27.7, the second highest in its 140-year history and 66% above its long-term average. In comparison, the CAPE ratio is 7.7 for Portugal, 9.6 for Italy and about 11.0 for Ireland and Spain.

In the wake of the ECB’s asset quality review completed in October 2014, European banks have made good progress in strengthening their balance sheets. Although year-over-year euro bank lending was down -0.5% in December, it will likely turn positive in the first half of 2015. Since European banks provide almost 80% of credit creation in the eurozone, the improving health of European banks is probably more important than the ECB’s QE program in lifting economic growth throughout the eurozone. We continue to expect the eurozone to grow 1.3% in 2015.


The Japanese economy slipped into a recession in the second and third quarters of last year. Although GDP grew 2.2% in the fourth quarter, it was well short of the 3.6% growth rate forecast by economists. Consumers account for 60% of Japan’s GDP and spending increased only 0.3% in the fourth quarter—for good reason. Over the last 18 months, base wages have lagged behind the cost of living primarily because the cost of imports has risen significantly due to the 40% depreciation in the yen since November 2012. We first discussed the potential of this problem in our February 2013 MSR. Japan only produces 16% of its energy needs domestically. Since natural gas, coal and oil are priced in dollars, the decline in the yen has caused the cost of these and other imports to exceed wage growth, even after accounting for the decline in the price of these commodities.

The Bank of Japan has become so concerned about the decline in real wages that it decided in early February to postpone any additional quantitative easing that might result in a further decline in the yen. This decision may have been partially due to local elections in April but also to await the results of the annual wage talks between corporations and labor groups. The negotiations, known as Shunto, have been a tradition since the 1950s when agreements by large manufacturers and unions set the wage pace for other industries. This year’s negotiations are critical if Japan is going to finally escape the grip of deflation and 20 years of subpar growth. Japanese Prime Minister Shinzo Abe and BoJ Governor Haruhiko Kuroda have been pressuring public companies to pass on more of their record profits to their workers. Japanese public companies have greatly benefited from the doubling in the Japanese stock market and the yen’s decline since November 2012. It is hoped that higher wages will spur consumer spending and Japan’s economy. Japan Business Federation, which includes 1,309 companies and is also known as Keidanren, supports an increase of at least 2.2%. The Japan Trade Union Confederation is seeking a raise of at least 4%, the largest request since 1998. Since the sales tax was increased from 5% to 8% in April 2014, consumer spending has been weak and would surely benefit from a meaningful increase in wages. Last year’s increase of 2.2% by the Keidanren was the first increase above 2% since 2001 and obviously wasn’t enough. If wage increases prove insufficient, we have no doubt that the BoJ will embark on another round of QE. Abenomics is an exercise in desperation and the BoJ has no choice but to keep throwing Hail Mary passes until one is completed or the whistle blows signaling the game is over.

Dollar – Technical Analysis

As discussed last month, the dollar reached our initial upside target of 95.00 – 96.00 and we thought that a consolidation that chews up time was more likely than a huge correction in price. So far, that’s what has occurred. We still think a pullback to 92.60, the high in November 2005, is likely and the most we would expect is a retest of the highs recorded in 2008, 2009 and 2010, which were between 88.00 and 89.50. Longer term, we expect the dollar to reach 101.00 – 102.00 before the end of 2015.

Euro Reversal Gold and Gold Stocks – Fundamental and Technical Reasons for a Rally

Almost 50% of the cost of extracting precious metals is related to energy, so the decline in oil prices lowers the cost of production significantly and disproportionately benefits precious metal mining producers compared to other industrial companies. Most of the precious metal mines are located in emerging countries whose currencies have fallen relative to the dollar, especially since last May. Since wages are paid in the local currency and gold, silver and platinum are sold in dollars, profit margins for producers have widened even though the dollar prices for precious metals have fallen. The improvement in the fundamentals for precious metal producers may not be fully appreciated by the market. Producers, however, are not cutting production even though precious metal prices have fallen because their margins haven’t suffered. This suggests that gold mining stocks may be ready to rally, but the rally may not be sustained since producers haven’t lowered production and may even increase production if gold enjoys a short-term rally as we expect.

In 2013, gold twice bottomed near $1,180, so this is an important technical level. We think gold can rally above the high in January as long as it does not close below $1,175. If it does close below $1,175, the potential for a decline to below the $1,130 November low would increase.

Treasury Bonds

Last month we thought that the yield on the 10-year U.S. Treasury bond would be range-bound between 1.60% and 2.10% until more clarity developed about the timing of the Fed’s first rate hike. On January 30, the yield dropped to 1.65% and then rose to 2.15% on February 17, effectively traversing the range we thought would last for several months in less than three weeks! The 10-year Treasury yield has held within a downward sloping channel since September 2013 with only a few outside excursions. After falling below the lower channel line in January, the rebound to 2.152% brought the yield back into the channel. As of February 24, the yield on the 10-year Treasury has fallen to 1.99%, below the lower channel line near 2.05%. Should the yield close above 2.20%, a run up to 2.35% or so, which was the low last August and high in early November, is possible. The ECB will begin buying sovereign bonds soon, which is likely to keep yields from increasing much throughout the eurozone. The low yields in Europe make the 10-year Treasury yield look like a bargain, so the ECB’s purchases should help keep the yield on the 10-year fairly stable.

The economy has slowed as we expected, which could help keep a lid on yields in the U.S. and increase the odds that the Fed will not increase rates in June as many expect. According to TD Securities, short-term traders and hedge funds had accumulated $3.26 billion in short positions in Treasury bonds as of February 10. This is the largest net short position since weekly data became available in March 2010. These short positions represent future demand and limit how much Treasury yields can rise in coming months. We think the yield on the 10-year Treasury is likely to remain range-bound between 1.65% and 2.20% for longer than the next three weeks.


In 1953, Charles Wilson, president of General Motors (GM), was nominated for Secretary of Defense by President Eisenhower. During his Senate confirmation hearing, Wilson was asked if he would have a problem making governmental decisions that might not be in the interest of GM. Wilson responded affirmatively and added:

“For years I thought what was good for the country was good for General Motors and vice versa.”6

Over time his quote was modified to “What’s good for General Motors is good for the country” and eventually became “As General Motors goes, so goes the nation.” Sixty years later, it’s time for a makeover. So often, as we observe people in airports, buses or on Bart commuter trains around San Francisco, most are staring at an Apple product or feverishly tapping away on a keypad. Alexander Graham Bell would really be confused to see so many people texting rather than using a phone to actually converse with another person—he actually thought the telephone was a leap forward compared to the Morse code! Apple’s market capitalization is more than $775 billion, which would make it the 19th largest country in the world based on total GDP, ahead of Saudi Arabia, Switzerland and 173 other countries. Given this state of affairs and the change in social behavior, we think the new slogan should be, “As Apple goes, so goes the nation,” or maybe even more fittingly, “As Apple goes, so goes the stock market.” Through February 23, the NASDAQ-100 Index has gained 213 points for the year and Apple has contributed 141 points, or 66.2%, to the increase.

As we noted in the January and February MSRs, as long as the S&P 500 Index is able to hold above 1,972, the uptrend is still intact. The index bottomed on February 2 at 1,980.90 and has rallied to a new high. It continues to make higher highs and higher lows, the technical definition of an uptrend, which will remain intact as long as it does not close below 1,980. Furthermore, the rally since the February 2 low has been good, with the majority of major market averages hitting new highs along with the New York Stock Exchange (NYSE) advance-decline (A/D) line. The Major Trend Indicator (MTI) has improved significantly during the recent rally and will likely reconfirm the bull market in the next two weeks. Historically, large market declines are preceded by divergences between market averages (as some make a new high and others do not), a failure by the A/D line to make a new high and a weak reading on the MTI. Since a majority of the technical indicators that measure the market’s internal strength are in decent shape, declines are likely to be limited to 4% to 7% during the next one to three months.

The recent surge in bullish sentiment is worrisome from a longerterm perspective. Hedge funds’ net long position is up to 57%— the highest ever. In the Investors Intelligence weekly survey of sentiment for the week ending February 20, there were four times as many bulls than bears, one of the highest levels in the last 30 years. When a majority of investors finally embrace a bull market that is approaching its sixth birthday, the contrarian in us knows the time for vigilance is near.

Definition of Terms

10-year Treasury is a debt obligation issued by the U.S. Treasury that has a term of more than one year, but not more than 10 years.

An advance-decline (A/D) line is a technical indicator that plots changes in the value of the advance-decline index over a certain time period.

Asset-backed security is a financial security backed by loans, leases, credit card debt or receivables against assets other than real estate and mortgage-backed securities.

Borsa Italiana S.p.A., based in Milan, is Italy’s main stock exchange. It was privatized in 1997 and has been a part of the London Stock Exchange Group since 2007.

CAC 40 (Cotation Assistée en Continu) is a benchmark French stock market index. The index represents a capitalization-weighted measure of the 40 most significant values among the 100 highest market caps on the Euronext Paris (formerly the Paris Bourse).

Citi Economic Surprise Indices are objective and quantitative measures of economic news. They are defined as weighted historical standard deviations of data surprises.

Consumer price index (CPI) is an index number measuring the average price of consumer goods and services purchased by households. The percent change in the CPI is a measure of inflation.

Cyclically adjust price-earnings (CAPE) ratio measures the value of the S&P 500 equity market.

DAX (Deutscher Aktienindex) is a German blue chip stock market index consisting of the 30 major German companies trading on the Frankfurt Stock Exchange.

Debt-to-GDP ratio is a measure of a country’s federal debt in relation to its gross domestic product (GDP). By comparing what a country owes to what it produces, the debt-to-GDP ratio indicates the country’s ability to pay back its debt.

Devaluation is a monetary policy tool whereby a country reduces the value of its currency with respect to other foreign currencies.

Employment cost index (ECI) is a quarterly report from the U.S. Department of Labor that measures the growth of employee compensation (wages and benefits) based on a survey of employer payrolls in the final month of each quarter.

Federal funds rate is the interest rate at which a depository institution lends immediately available funds to another depository institution overnight.

Federal Open Market Committee (FOMC) is a branch of the Federal Reserve Board that determines the direction of monetary policy.

Gross domestic product (GDP) is the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports. The GDP of a country is one of the ways of measuring the size of its economy.

Institute of Supply Management (ISM) Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries based on surveys of more than 300 manufacturing firms.

ISM Manufacturing New Export Orders Index reports on the level of orders, requests for services and other activities to be provided outside of the United States.

Major Trend Indicator is a proprietary technical tool that measures the strength or weakness of the market and helps identify bull and bear phases. During bull markets it helps indicate when the market may be vulnerable to a correction, and during bear markets it helps identify a potential rally.

NASDAQ-100 Index is a modified capitalization-weighted index that includes the largest nonfinancial U.S. and non-U.S. companies listed on the NASDAQ stock market across a variety of industries, such as retail, healthcare, telecommunications, wholesale trade, biotechnology and technology.

Personal Consumption Expenditures (PCE) Index is a measure of price changes in consumer goods and services. It is essentially a measure of goods and services targeted toward individuals and consumed by individuals.

Purchasing managers index (PMI) measures the health of the manufacturing sector and is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

Quantitative easing refers to a form of monetary policy used to stimulate an economy where interest rates are either at, or close to, zero.

Range-bound is when a market, or the value of a particular stock, bond, commodity or currency, moves within a relatively tight range for a certain period of time.

S&P 500 Index is an unmanaged index of 500 common stocks chosen to reflect the industries in the U.S. economy.

U.S. Dollar Index is a measure of the value of the U.S. dollar relative to six major world currencies: the euro, Japanese yen, Canadian dollar, British pound, Swedish krona and Swiss franc.

Volatility is a statistical measure of the dispersion of returns for a given security or market index.

One cannot invest directly in an index.

  1. Binyamin Appelbaum, “Q. and A. With Charles Plosser of the Fed: Raise Rates Sooner Rather Than Later,” New York Times, January 30, 2015.
  2. Michael S. Derby, “Fed’s Bullard Shrugs Off Inflation Expectations Drop, Favors Rate Rises,” Wall Street Journal, February 3, 2015.
  3. Minutes of the Federal Open Market Committee, January 27-28, 2015.
  4. Binyamin Appelbaum, “Q. and A. With Charles Plosser of the Fed: Raise Rates Sooner Rather Than Later,” New York Times, January 30, 2015.
  5. ECB press release, “ECB announces expanded asset purchase programme,” January 22, 2015.
  6. U.S. Department of Defense, “Charles E. Wilson, 5th Secretary of Defense,”


Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results. This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.

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